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We’ve been neutral on KRW as the rising geostrategic tensions on the Korean peninsula has certainly impacted domestic market sentiment. The USDKRW cross is 2% above the year-to-date lows, the KOSPI equity index is down over 3% in the past month (with foreign investors pulling USD3.3bn from local stocks since late July), and 5yr CDS is up 10bps over the same period.
However, these moves are very much within the historical norms in terms of periods of heightened tensions.
Consequently, we confer the EM volatility landscape in ‘Opportunities in EM FX Options’ and suggest that buying a USDKRW double no-touch is now compelling: Fading North Korea risk premium. Selling volatility outright with unbounded risk is unfavorable given unquantifiable price action in the event of a tail risk outcome. Owning volatility is expensive, and we favor currency pairs with lower absolute vol and less extended skew (such as TWD and CNH) to hedge North Korea risk.
A limited loss structure in KRW within the gamma bucket (1m-3m) is more appealing to fade this risk premium. Entry point within the trading range. The entry point is appealing, with USDKRW trading close the middle of the six-month intraday range (1,110-1,161). The top-end should hold if North Korea risk premium subsides and the lower end could be protected by intervention. Pressure on EM vol. EM FX vol should compress absent a negative growth shock in the US or China amid a glacial pace of DM policy normalization, helping to drag down KRW vol.
Sell volatility in limited loss structure USDKRW 3m implied volatility is up by two vol points since the North Korean hostilities began after falling three vol points prior to that. An easing of tensions should see volatility compress alongside the general trend in EM. The richness of implied versus realized vol is at the high end of the five-year range, suggesting an opportune time to harvest vol premium.
Furthermore, KRW skew and convexity is by far the most expensive within the EM universe, indicating that short vol strategies could be favorable. Thus, buy USDKRW 3m double no-touch, knock-out 1,109/1,162 Indicative offer: 11% (spot ref: 1131). Maximum leverage: 9 times.
